Madoff Trustee Scores Major Victory at Second Circuit: Inquiry Notice, Red Flags and What it All Means to the Recovery Effort for Victims of Madoff’s Ponzi Scheme

A U.S. Appeals Court has provided renewed hope for the Trustee tasked with recovering billions of dollars for victims of Bernie Madoff’s massive Ponzi Scheme, ruling that a district court applied an incorrect (and more difficult) standard in preventing the Trustee from recovering subsequent recipients of transfers from the now-defunct investment company. In Picard v. Citibank N.A., 20-01333, Second U.S. Circuit Court of Appeals (Manhattan), published on August 30, 2021, the Second Circuit revived two lawsuits filed by Trustee Irving Picard¹ against various recipients of allegedly fraudulent transfers from Madoff’s firm after concluding that the district court erred in applying a stricter pleading standard. The decision promises to have sweeping ramifications going forward and further increases the possibility that Madoff’s victims could recover 100% of their losses through the Trustee’s efforts. 

Following Madoff’s arrest, the Securities Investor Protection Corporation moved under its authority pursuant to the Securities Investor Protection Act (SIPA) to appoint Picard as a trustee to liquidate Madoff’s investment firm. Since his appointment, Picard has filed hundreds of “recovery actions” against dozens of defendants, who are “subsequent transferee” defendants under Section 550 of the Bankruptcy Code. The Picard decision is critical, resulting in over seven dozen such cases, totaling many billions of dollars that previously would have been subject to dismissal as a matter of law, are now immediately revived, and will likely survive any future motions to dismiss. One of these lawsuits was filed against Citigroup based on the receipt of over $343 million from a “feeder fund” that had used funds borrowed from Citigroup to invest with Madoff. Despite Picard’s argument that Citigroup should be required to return the money because it was on notice of the potential fraud, U.S. District Court Judge Rakoff ruled that the claims were subject to a stricter “willful blindness” pleading standard and thus Picard was required to show that Citi had acted with “willful blindness” to “red flags” of possible fraudulent activity. In addition, Judge Rakoff found that the Trustee was required to plead the defendant-transferee’s lack of good faith. Based on this guidance, the bankruptcy court subsequently dismissed the case against Citi (and others similarly situated).

But, on appeal to the Second Circuit, the appeals court vacated the dismissals and ruled that Judge Rakoff had erred by applying the stricter “willful blindness” pleading standard and by shifting the burden of pleading lack of good faith to the Trustee. Instead, the Second Circuit ruled that “lack of good faith in a SIPA liquidation applies an inquiry notice, not willful blindness, standard, and that a SIPA trustee does not bear the burden of pleading the transferee’s lack of good faith.” In doing so, the Second Circuit explained that the plain meaning of the relevant sections of the Bankruptcy Code “embraces an inquiry notice standard” and noted that its sister circuits had “unanimously accept[ed] an inquiry notice standard.” The Second Circuit also rejected the District Court’s theory that the Trustee bore the burden of pleading lack of good faith, concluding that good faith is an affirmative defense under the relevant provisions of the Bankruptcy Code and that a different result is not warranted simply because the Trustee is proceeding under the SIPA.  

Application of the inquiry notice standards gives new life to similar recovery efforts such as the Trustee’s suits filed against Legacy Capital Ltd., a British Virgin Islands corporation that invested solely with Madoff, for $213 million and Khronos LLC, for $6.6 million. In real terms, this decision means that in twelve years of the Madoff recovery effort, complex cases against sophisticated institutional investors and defendants are incredibly, still at the very embryonic stages. The recovery effort shall persist for years to come, which could result in billions more being returned to Madoff’s defrauded victims – who have already been the beneficiary of Picard’s recovery of nearly $15 billion to date.

Madoff was arrested in 2008 and subsequently admitted to running the largest Ponzi scheme in history. He died in April while serving a 150-year sentence in federal prison.